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Using Affine Jump Diffusion Models for Modelling and Pricing Electricity Derivatives

Using Affine Jump Diffusion Models for Modelling and Pricing Electricity Derivatives A seasonal affine jump diffusion spike model with regime switching in the long‐run equilibrium level is applied to model spot and forward prices in the Scandinavian power market. The spike part of the model incorporates different coefficients of mean reversion in the spike and normal variables and thus improves the spot–forward relationship, particularly at time periods when spikes occur. The regime switching part of the model contains two separate regimes to distinguish between periods of high and low water levels in the reservoirs, reflecting the availability of hydropower in the market. The performance of the models is compared with that of other models proposed in the literature in terms of fitting the observed term structure, as well as by generating simulated price paths that have the same statistical properties as the actual prices observed in the market. In particular, the model performs well in terms of capturing the spikes and explaining their fast mean reversion as well as in terms of reflecting the seasonal volatility observed in the market. These issues are very important for the pricing and hedging of derivative instruments. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Applied Mathematical Finance Taylor & Francis

Using Affine Jump Diffusion Models for Modelling and Pricing Electricity Derivatives

Nomikos, N. K.; Soldatos, O.
Applied Mathematical Finance , Volume 15 (1): 31 – Feb 1, 2008
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Using Affine Jump Diffusion Models for Modelling and Pricing Electricity Derivatives

Abstract

A seasonal affine jump diffusion spike model with regime switching in the long‐run equilibrium level is applied to model spot and forward prices in the Scandinavian power market. The spike part of the model incorporates different coefficients of mean reversion in the spike and normal variables and thus improves the spot–forward relationship, particularly at time periods when spikes occur. The regime switching part of the model contains two separate regimes to distinguish between...
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Publisher
Taylor & Francis
Copyright
Copyright Taylor & Francis Group, LLC
ISSN
1466-4313
eISSN
1350-486X
DOI
10.1080/13504860701427362
Publisher site
See Article on Publisher Site

Abstract

A seasonal affine jump diffusion spike model with regime switching in the long‐run equilibrium level is applied to model spot and forward prices in the Scandinavian power market. The spike part of the model incorporates different coefficients of mean reversion in the spike and normal variables and thus improves the spot–forward relationship, particularly at time periods when spikes occur. The regime switching part of the model contains two separate regimes to distinguish between periods of high and low water levels in the reservoirs, reflecting the availability of hydropower in the market. The performance of the models is compared with that of other models proposed in the literature in terms of fitting the observed term structure, as well as by generating simulated price paths that have the same statistical properties as the actual prices observed in the market. In particular, the model performs well in terms of capturing the spikes and explaining their fast mean reversion as well as in terms of reflecting the seasonal volatility observed in the market. These issues are very important for the pricing and hedging of derivative instruments.

Journal

Applied Mathematical Finance – Taylor & Francis

Published: Feb 1, 2008

Keywords: Regime‐switching spike model; affine jump diffusion models; electricity derivatives; seasonal risk premium; JEL Classification: G13; G12 and G33

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